There are many things Arthur Laffer could be accused of. Sitting on the fence isn’t one of them.

At 73, the man dubbed the “father of supply-side economics” is as strong in his conviction today that high taxes stifle growth as when he advised former US president Ronald Reagan in the 1970s and Margaret Thatcher in the 1980s.

According to economics lore, it all began at the Two Continents Restaurant at the Washington Hotel in 1974. Laffer was dining with Dick Cheney and Donald Rumsfeld, who were working under then president Gerald Ford. The conversation turned to tax, and Laffer, arguing against Ford’s proposed tax rises, sketched a curve on one of the restaurant’s napkins to illustrate the trade-off between tax rates and tax revenues.

Laffer said higher tax rates produced diminishing returns after a certain point because onerous rates discouraged people to work. Using this principle, Laffer argued that in some cases, cutting taxes could actually raise more revenues. With this, the “Laffer Curve”, influenced by John Maynard Keynes and 14th century philosopher Ibn Khaldun, was born.

To this day, Laffer does not fully recall the events of that evening – but more of that later. The American economist, who will be in London this week for the Margaret Thatcher Conference on Liberty, has fond memories of the former prime minister. The Iron Lady famously slashed the top rate of tax, which was 83pc when she came to power in 1979 to 40pc by 1988. Increasing VAT from 8pc to 15pc helped to fund a reduction in the basic rate of tax to 25pc, from 33pc.

Controversial though it was, Thatcher’s successors left the top rate at 40p until 2010, when the Labour Government introduced a new 50p rate on all income above £150,000. The Coalition has since reduced this to 45p but Laffer argues the Government should abolish it altogether.

“It’s already done long-term damage having it at 45p rather than 40p,” he says.

Laffer claims that if the Government scrapped the top rate and “levelled the playing field” at the top it would entice more people to work here, generating more income for the Exchequer.

“If you lowered the tax to 40p, your prosperity would come back, your revenues, your budgets would come back and you would get back what you had. And if you lowered it even further, Britain would even do a better job.”

Official estimates show that reducing the top rate of tax to 45p cost the Exchequer just £100m but there is a more important point.

According to the Institute for Fiscal Studies, the 1pc of taxpayers earning in excess of £150,000 now pay between 25pc and 30pc of all income tax, up from 21pc a decade ago. Tinkering with the way this group are taxed carries a risk for any chancellor.

Laffer’s solution is simple: introduce a flat tax that would bundle together income tax and national insurance, get rid of tax credits and the “absolutely offensive” inheritance tax.

According to Laffer, a flat tax would discourage “gaming” of the system, level out the playing field and ultimately generate more revenues.

“Taxes change all sorts of incentives, and that’s why you want to have a tax system that allows for the least gaming of the tax code,” he says.

“Taxes should be there to collect revenues. If you’ve got poor people whom you want to help, don’t play around with taxes. You can’t help poor people with taxes but you can spend money on them. “Under a flat tax, everyone pays the same rate so there’s not an incentive for tax dodgers and loophole seekers and lawyers and favour grabbers and consultants and deferred income specialists and accountants. Let them all get real jobs!”

A flat tax is radical but not impossible to implement. Back in 2005, Chancellor George Osborne spoke out in favour of a flat tax, while a study by the Adam Smith Institute suggested introducing it at 22pc, supported by a higher personal allowance of £12,000 (up from £4,740), would yield long-term benefits despite an initial £40bn black hole. More recently, the 2020 Tax Commission called for a 30pc flat rate of income tax, with National Insurance, inheritance tax and stamp duty on shares scrapped altogether.

A flat tax has been the norm in several Eastern European countries for decades. Estonia introduced a flat tax of 26pc in 1994, clinging to a 21pc rate during the depths of the financial crisis and opting instead to raise revenues by raising the value-added tax and slashing government spending. The deficit never exceeded 3pc of GDP during the crisis, and the budget has been mostly in surplus since then. Yet some other flat-tax converts in the region, such as Ukraine and Belarus, are economic basket cases, while Slovakia has abandoned its flat tax in favour of a more progressive system.

Laffer admits that introducing a flat tax in the UK would face too many political hurdles: “But you’ve got to have a vision of what the world should be so you can always judge policies as to whether they can move you towards what it should be, or away from what it should be.”

Laffer has attracted as many critics as admirers. They claim that the Reagan tax cuts and Bush cuts in 2001 and 2003 actually reduced revenues and pushed the deficit higher. Harvard professor Jeffrey Frankel argued that while tax cuts could raise more revenues under certain conditions, common sense would suggest that overall cuts reduce revenues.

Laffer says it’s more complicated than that, citing the example of cutting capital gains tax, which encourages investment and therefore increases the tax yield from income taxes, corporate profits taxes and sales taxes.

A recent Treasury analysis found that government plans to reduce corporation tax to 20pc next year from 28pc in 2010 would increase the size of the economy by between 0.6pc and 0.8pc.

Laffer points out that punitive tax rates suffered by US companies wishing to return money to the US will spark more inversion deals, such as drugs giant Pfizer’s attempted takeover of AstraZeneca.

“Do you really want businesses to make decisions based on their taxes? No-one does. Businesses should do business because it’s good for business, not basing their decisions on tax codes.”

Forty years on, the Laffer curve is still causing a stir, but what exactly happened that night in Washington? “I would have dinner every week with Donald Rumsfeld when he came back from NATO,” recalls Laffer. “He invited his deputy and my classmate from Yale, Dick Cheney, and I invited my friend Jude Wanniski. “At the end of the dinner, Jude picked up the napkin and it’s now held by his wife.

“I denied it was on a cloth napkin until I actually saw it. Can you imagine going to a fine restaurant and drawing on a fine napkin? If my mum knew, she’d say, Arthur, get a piece of paper – please.”

The Margaret Thatcher Conference on Liberty takes place on Wednesday June 18. Join the conversation on Twitter:@CPSThinkTank #Liberty2014

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About bambooinnovatorKB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund.
Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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